Maximizing 401(k) savings Tax Talk by George Saenz, CPA • Bankrate.com

Dear Tax Talk,
I recently graduated from law school and am working at a large law firm in the South. Being broke for so long has made me conscious of money, so now that I am making a decent living I want to know how to maximize my income. I want to know how much to put in my 401(k) so that I can maximize my tax situation. In other words, how much am I able to put in my 401(k) pretax so that the money I would have paid in taxes will instead go into my savings? I make about $120,000 a year and I have other pretax deductions totaling about $225 a month. I also own a home as well. Any help will be great.
-- Alan

Dear Alan,
In 2006, the maximum 401(k) deferral is $15,000 ($20,000 for folks of age 50 and over). When you defer part of your salary to a 401(k) plan, you avoid income tax on the deferred amount. FICA and Medicare tax are still withheld on the deferral. By funding your 401(k), you are saving the income tax that you would otherwise have had withheld from your paycheck. In effect, the government is giving you the tax money to put in your retirement plan. This means your gross paycheck is not reduced by the full amount of the 401(k) contribution, but instead by the contribution less your tax savings.

In your case you are making $10,000 a month, which puts you in a 28 percent tax bracket for withholding. If you put the monthly maximum of $1,250 in your 401(k), the IRS is giving you $350 of the contribution. Your paycheck with and without the contribution would be as follows:

Uncle Sam contributes to your 401(k) account

Though you're socking away $1,250 a month, your net check only goes down by about $900.

Note, however, that the tax-deferred nature of the 401(k) ends at the point when you retire and begin taking withdrawals. The distributions will be taxed at ordinary income tax rates.

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